According to Investopedia, 630,000 companies are traded publically on stock exchanges around the world.
Of these, less than 5,000 trade on US exchanges and 2,080 are listed on the London Stock Exchange, which claims to be the world’s most international of global exchanges.
With so many options out there, investors are spoilt for choice when it comes to choosing investments. But this level of choice is not necessarily a good thing.
Most companies underperform
Of the thousands of public companies in the US, only a handful have outperformed their respective stock indexes over the long term. The rest have either matched or underperformed.
One of the most informative studies on this topic was published in 2017. Do Stocks Outperform Treasury Bills? by Professor Hendrik Bessembinder from the University of Arizona found that since 1926, less than half of stocks generated any returns for investors.
Just 42.1% of the stocks analysed earned more than risk-free treasury bills over the entire period.
Further analysis of the 26,000 stocks that traded during these 90 years showed that just 4% of these companies accounted for all of the market gains. The remaining 96% only produced returns that merely equalled the amount earned through treasury bills.
There are two conclusions we can draw from this data. Firstly, picking stocks is really, really hard. And secondly, you only need one or two good investment ideas to beat the market over the long term.
Picking the best ideas
Picking stocks is not easy, but no investor is ever under any obligation to buy a security. Being inactive and not taking a position is just as important as being active.
Unfortunately, most investors and investment managers find it too hard to sit on their hands. And this is where so many slip up.
Rather than buying just one or two good companies and sitting on them for decades, most investors are driven by an impulse to act, whether out of boredom or frustration or some other psychological factor that leads to irrational thinking.
The fact of the matter is, every investor has a lot of mediocre and good investment ideas. However, what really separates the average investor from the great investor is the great investor’s restraint to only act on one or two of their best ideas, and say “no” to everything else.
Warren Buffett tried to get this point across in a lecture to University of Notre Dame students in the spring of 1991. Here’s what he told students:
“I would say that almost everybody I know in Wall Street has had as many good ideas as I have, they just had a lot of [bad] ideas too. And I’m serious about that. I mean when I bought Western Insurance Security selling at $16 and earning $20 per share, I put half my net worth into it. I checked it out first – I went down to the insurance commission and got out the convention statements, I read Best’s and I did a lot of things first. But, I mean, my Dad wasn’t in it, I’d only had one insurance class at Columbia – but it was not beyond my capabilities to do that, and it isn’t beyond your capabilities.”
But what about diversification?
Diversification is widely considered to be the best way to reduce risk in a portfolio, an insurance policy against investment mistakes.
The question is, why should you need an insurance policy against mistakes if you’ve done your research? If you think you found a great company with bright prospects, why is there any need to dilute your potential returns by diversifying your portfolio?
After all, we know that most stocks fail to outperform treasury bills over the long-term. Why would you accept this lower return unless you have no confidence in your ideas?
If you’ve done your research and honestly believe that the company you own has the potential to produce market-beating long-term returns, there’s no need to diversify. If you have your doubts, it might be better to stay away and wait for another opportunity to come along.
On that note, I’m going to finish this article with a quote from Warren Buffett’s right-hand man, billionaire Charlie Munger, who’s never been a fan of diversification in a portfolio:
“If you students of America go to these elite business schools and law schools and they learn corporate finance the way it’s now taught and investment management the way it’s now taught. And some of these people write articles in the newspaper and other places and they say, “Well, the whole secret of investment is diversification.” That’s the mantra. They’ve got it exactly back-ass-ward. The whole secret of investment is to find places where it’s safe and wise to non-diversify. It’s just that simple. Diversification is for the know-nothing investor; it’s not for the professional.” — Charlie Munger